MARKET FAILURES:

Externalities and public goods

 Microeconomics
• Basic Economic concepts
• Suply, Demand and Market equilibrium
• Suply, Demand and Government Policies
• Elasticity
• International trade
• Market failures: Externality and Public goods
• Production and Cost
• Market structures
 Market failures

• Externalities (chapter 10)

• Public goods and common resources
(Chapter 11)
 Externalities

Honeybee Communication Cigarette smoke

A beekeeper creates positive externalities Secondhand smoke is an example of a
for her community because her bees negative externality; a person chooses to
pollinate the surrounding area's flowers smoke, but others who do not choose to
smoke are harmed.
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 Look for the answers to these questions:
• What is an externality?
• Why do externalities make market outcomes
inefficient?
• What public policies aim to solve the problem of
externalities?
• How can people sometimes solve the problem of
externalities on their own? Why do such private
solutions not always work?

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 Externalities
• ‘Markets are usually a good way to organize economy activity’
• In absence of market failures, the competitive market outcome is
efficient, maximizes total surplus
• Externality: one type of market failure
• The uncompensated impact of one person’s actions on the well-being of
a bystander
• ‘Government action can sometimes improve upon market
outcomes’
• Why markets sometimes fail to allocate resources efficiently
• How government policies can potentially improve the market’s allocation
• What kinds of policies are likely to work best
 Externalities
•Negative externality
• Impact on the bystander is adverse
•Positive externality
• Impact on the bystander is beneficial
•Self-interested buyers and sellers
• Neglect the external costs or benefits of their actions
• So the market outcome is not efficient
“Declining to be vaccinated against contagious diseases
such as measles imposes costs on other people, which is
a negative externality.”`

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 Negative Externalities

• Examples of negative externalities

• Air pollution from a factory
• The neighbor’s barking dog
• Late-night stereo blasting from the dorm room next to yours
• Noise pollution from construction projects
• Health risk to others from second-hand smoke
• Talking on cell phone while driving makes the roads less safe
for others

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Recap of Welfare Economics
P The market for gasoline • The market equilibrium
$5
maximizes consumer
+ producer surplus.
4

• Supply curve shows private

3
$2.50 cost, the costs directly
2
incurred by sellers.

1 • Demand curve shows private

value, the value to buyers (the
0 prices they are willing to pay).
0 10 20 25 30 Q
(gallons)
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 Analysis of a Negative Externality
P The market for gasoline
$5 Social cost
= private + external cost
4 external
Supply (private cost)
cost
3 External cost
= value of the negative impact
2
on bystanders
1 = $1 per gallon
(value of harm from smog,
0 greenhouse gases)
0 10 20 30 Q
(gallons)
12
 Analysis of a Negative Externality
P The market for gasoline
The socially optimal quantity is
$5
Social 20 gallons.
cost
4
S At any Q < 20,
3 value of additional gas exceeds
social cost.
2 At any Q > 20,
D social cost of the
1 last gallon is
greater than its value to society.
0
0 10 20 25 30 Q
(gallons)
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 Analysis of a Negative Externality
P The market for gasoline
$5 Market equilibrium
Social
cost (Q = 25)
4
S is greater than social optimum
3 (Q = 20).

2 One solution:
D tax sellers $1/gallon,
1
would shift S curve up $1.
0
0 10 20 25 30 Q
(gallons)
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 Externalities

•Internalizing the externality:

• Altering incentives so that people take into account the
external effects of their actions
• In our example, the $1/gallon tax on sellers makes
sellers’ costs = social costs.
•If market participants pay social costs
• Market equilibrium = social optimum

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1. An externality exists whenever 2. When externalities are present in a market,
a. the economy cannot benefit from the well-being of market participants
government intervention. a. and market bystanders are both directly
b. markets are not able to reach equilibrium. affected.
c. a firm sells its product in a foreign market. b. and market bystanders are both indirectly
d. Bobbi engages in an activity that influences affected.
the well-being of Rosa and yet Bobbi neither c. is directly affected, and market bystanders
pays nor receives payment for that influence. are indirectly affected.
3. When externalities exist, buyers and d. is indirectly affected, and market bystanders
sellers are directly affected.
a. neglect the external effects of their actions, 4. Which of the following is an example of
but the market equilibrium is still efficient. an externality?
b. do not neglect the external effects of their a. cigarette smoke that permeates an entire
actions, and the market equilibrium is restaurant
efficient. b. a flu shot that prevents a student from
c. do not neglect the external effects of their transmitting the virus to her roommate
actions, and the market equilibrium is not c. a beautiful flower garden outside of the local
efficient. post office
d. neglect the external effects of their actions, d. All of the above are correct.
and the market equilibrium is not efficient.
5. Dioxin emission that results from the production of paper is a good example of a negative externality
because
a. self-interested paper firms are generally unaware of environmental regulations.
b. there are fines for producing too much dioxin.
c. self-interested paper producers will not consider the full cost of the dioxin pollution they create.
d. toxic emissions are the best example of an externality.
6. Suppose that large-scale pork production has the potential to create ground water pollution. Why
might this type of pollution be considered an externality?
a. The groundwater pollution reduces the cost of large-scale pork production.
b. The pollution has the potential for creating a health risk for water users in the region surrounding the pork
production facility.
c. The economic impact of a large-scale pork production facility is localized in a small geographic area.
d. Consumers will not reap the benefits of lower production cost from large-scale pork production.
7. Which of the following statements is correct?
a. Internalizing a negative externality will cause an industry to decrease the quantity it supplies to the market
and increase the price of the good produced.
b. Internalizing a negative externality will cause an industry to decrease the quantity it supplies to the market
and decrease the price of the good produced.
c. Internalizing a negative externality will cause an industry to increase the quantity it supplies to the market
and decrease the price of the good produced.
d. Internalizing a negative externality will cause an industry to increase the quantity it supplies to the market
and increase the price of the good produced.
8. Private markets fail to account for externalities because
a. externalities don't occur in private markets.
b. sellers include costs associated with externalities in the price of their product.
c. decisionmakers in the market fail to include the costs of their behavior to third parties.
d. the government cannot easily estimate the optimal quantity of pollution.

9. Which of the following statements is not correct?

a. Without government intervention, the market will tend to undersupply products that produce
negative externalities.
b. Government policies may improve the market's allocation of resources when negative externalities
are present.
c. Government policies may improve the market's allocation of resources when positive externalities
are present.
d. A positive externality is an example of a market failure.

10. When the government intervenes in markets with externalities, it does so in order to
a. increase production when negative externalities are present.
b. protect the interests of bystanders.
c. make certain all benefits are received by market participants.
d. reduce production when positive externalities are present.
 Positive Externalities

• Being vaccinated against contagious diseases protects

not only you, but people who visit the salad bar or
produce section after you
• Research and development creates knowledge others
can use
• People going to college raise the population’s education
level, which reduces crime and improves government

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 Positive Externalities
•With a positive externality
• The social value of a good includes
• Private value – the direct value to buyers
• External benefit – the value of the positive impact on
bystanders
•The socially optimal Q maximizes welfare:
• At any lower Q, the social value of
additional units exceeds their cost.
• At any higher Q, the cost of the last unit exceeds its social
value.
 Analysis of a positive externality
P The market for flu shots
$50 •External benefit
= $10/shot
40
• Draw the social value
30
S curve.
• Find the socially
20 optimal Q.
• What policy would
10
D internalize this
0 Q
externality?
0 10 20 30
21
 P The market for flu shots
Socially optimal Q
$50
external = 25 shots.
40 benefit
To internalize the externality,
S use subsidy = $10/shot.
30

20 Social value
= private value + $10 external benefit
10
D

0 Q
0 10 20 25 30
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11. In a certain city, the local government regulates the destruction of historic buildings and provides
tax breaks to owners of historic buildings who restore them. These government policies
a. reflect the fact that restored historic buildings convey a positive externality.
b. reflect the fact that the destruction of historic buildings conveys a positive externality.
c. are likely to worsen the market failure that is associated with historic buildings and the restoration of such
buildings.
d. are likely to decrease the well-being of society as a whole.
12. If consumption generates negative externalities, unregulated firms will produce output at levels
that:
a. exceed the socially optimal quantity.
b. are socially optimal for the good.
c. are less than the socially optimal quantity.
d. consider marginal social benefits appropriately.

13. University researchers create a positive externality because what they discover in their research labs
can easily be learned by others who haven't contributed to the research costs. If there are no subsidies,
what is the relationship between the equilibrium quantity of university research and the optimal
quantity of university research produced?
a. They are equal.
b. The equilibrium quantity is greater than the socially optimal quantity.
c. The equilibrium quantity is less than the socially optimal quantity.
d. There is not enough information to answer the question.
14. If the government were to impose a fine of $4,000 for each unit of air-pollution released by a fertilizer
plant, the policy would be considered
a. a subsidy.
b. a regulation.
c. a corrective tax.
d. an application of the Coase theorem.

15. If the government wanted to ensure that the market reaches the socially optimal equilibrium in the
presence of a technology spillover, it should
a. impose a corrective tax on any firm producing a technology spillover.
b. offer tax credits to consumers who are adversely affected by the new technology.
c. subsidize producers by an amount equal to the value of the technology spillover.
d. provide research grants to those firms not currently engaging in research to increase competition in the
industry.

16. Flu shots provide a positive externality. Suppose that the market for vaccinations is perfectly
competitive. Without government intervention in the vaccination market, which of the
following statements is correct?
a. At the current output level, the marginal social benefit exceeds the marginal private benefit.
b. The current output level is inefficiently low.
c. A per-shot subsidy could turn an inefficient situation into an efficient one.
d. All of the above are correct.
 Effects of Externalities: Summary

• If negative externality
• Market quantity larger than socially desirable
• If positive externality
• Market quantity smaller than socially desirable
• To remedy the problem, “internalize the externality”
• Tax goods with negative externalities
• Subsidize goods with positive externalities

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 Public Policies Toward Externalities
• Command-and-control policies
• Regulate behavior directly
• Limits on quantity of pollution emitted
• Requirements that firms adopt a particular technology to reduce
emissions
• Market-based policies
• Incentives so that private decision makers will choose
to solve the problem on their own
• Corrective taxes and subsidies
• Tradable pollution permits
 Public Policies Toward Externalities

• Corrective taxes and subsidies

• Corrective taxes (Pigovian taxes)
• Induce private decision makers to take account of the social
costs that arise from a negative externality
• Places a price on the right to pollute
• Reduce pollution at a lower cost to society
• Raise revenue for the government
• Enhance economic efficiency
 Corrective Taxes vs. Regulations
• Different firms
• Have different costs of pollution abatement
• Efficient outcome
• Firms with the lowest abatement costs reduce pollution the most
• A pollution tax is efficient:
• Firms with low abatement costs will reduce pollution to reduce their
tax burden.
• Firms with high abatement costs have greater willingness to pay tax.
• Regulation requiring all firms to reduce pollution by a specific
amount
• Is not efficient
 Corrective Taxes vs. Regulations

• Corrective taxes are better for the environment:

• The corrective tax gives firms incentive to continue
reducing pollution as long as the cost of doing so is
less than the tax
• If a cleaner technology becomes available, the tax gives
firms an incentive to adopt it
• In contrast, firms have no incentive for further
reduction beyond the level specified in a regulation

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 Example of a Corrective Tax: The Gas Tax

The gas tax targets three negative externalities:

• Congestion
The more you drive, the more you contribute to congestion.
• Accidents
Larger vehicles cause more damage in an accident.
• Pollution
Burning fossil fuels produces greenhouse gases.
17. Suppose that the production of plastic creates a
social cost which is depicted in the graph. Without
any government regulation, what price will the firm
charge per unit of plastic?
a. $4.00
b. $6.00
c. $7.00
d. $10.00

18. What is the socially optimal quantity of plastic?

a. 200 units
b. 450 units
c. 500 units
d. 650 units

19. What is the amount of corrective tax that

government can collect?
a. $4
b. $1
c. $3
d. $2000
 Reducing pollution
Acme and US Electric run coal-burning power plants. Each emits 40 tons
of sulfur dioxide per month, total emissions = 80 tons/month.
• Goal: Reduce SO2 emissions 25%, to 60 tons/month
• Cost of reducing emissions:
• $100/ton for Acme
• $200/ton for US Electric
Policy option 2: Tradable pollution permits
Policy option 1: Regulation Issue 60 permits, each allows one ton SO2 emissions.
Every firm must cut its emissions 25% Give 30 permits to each firm.
(10 tons). Establish market for trading permits.
Your task: Compute the cost to each Each firm may use all its permits to emit 30 tons,
firm and total cost of achieving goal may emit < 30 tons and sell leftover permits,
using this policy. or may purchase extra permits to emit > 30 tons.

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 Tradable pollution permits
Items ACME USE TOTAL
Total emissions (tons)
Objectives (tons)
SO2 reduction
Cost of reduction (/ ton)
Total cost of reduction
SO2 reduction
Total cost of reduction
Cost for each firm
 POLUTION POLICY
Policy option 1: Regulation
Every firm must cut its emissions 25% (10 tons).
Your task: Compute the cost to each firm and total cost of
achieving goal using this policy.
Each firm must reduce emissions by 10 tons.
Cost of reducing emissions: $100/ton for Acme, $200/ton for US Electric.
• Compute cost of achieving goal with this policy:
• Cost to Acme: (10 tons) x ($100/ton) = $1000
• Cost to USE: (10 tons) x ($200/ton) = $2000
• Total cost of achieving goal = $3000

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 Tradable pollution permits
Goal: reduce emissions from 80 to 60 tons
Cost of reducing emissions: $100/ton for Acme, $200/ton for USE.
• Compute cost of achieving goal for Acme:
• Sells 10 permits to USE for $150 each, gets $1500
• Uses 20 permits, emits 20 tons SO2
• Spends $2000 to reduce emissions by 20 tons
• Net cost to Acme: $2000 − $1500 = $500
• Compute cost of achieving goal for USE:
• Buys 10 permits from acme, spends $1500
• Uses these 10 plus original 30 permits, emits 40 tons
• Spends nothing on abatement
• Net cost to USE = $1500
Total cost of achieving goal =$500+$1500=$2000
• Using tradable permits, goal is achieved at lower total cost and lower cost to each firm
than using regulation.
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20. Two firms, A and B, each currently emit 100 tons of chemicals into the air. The government
has decided to reduce the pollution and from now on will require a pollution permit for each
ton of pollution emitted into the air. The government gives each firm 40 pollution permits,
which it can either use or sell to the other firm. It costs Firm A $200 for each ton of pollution
that it eliminates before it is emitted into the air, and it costs Firm B $100 for each ton of
pollution that it eliminates before it is emitted into the air. It is likely that
a. Firm A will buy all of Firm B's pollution permits. Each one will cost between $100 and $200.
b. Firm B will buy all of Firm A's pollution permits. Each one will cost between $100 and $200.
c. Both firms will use their own pollution permits.
d. Firm A will buy some of Firm B's pollution permits. Each one will cost less than $100.
21. Two firms, A and B, each currently dump 50 tons of chemicals into the local river. It costs
Firm A $100 for each ton of pollution that it eliminates before it reaches the river, and it costs
Firm B $50 for each ton of pollution that it eliminates before it reaches the river. The
government gives each firm 20 pollution permits. What is the total cost of reducing pollution
if firms are not allowed to buy and sell pollution permits from each other? What is the total
cost of reducing pollution if the firms are allowed to buy and sell permits from each other?
a. $3,000; $1,500
b. $4,500; $3,500
c. $4,500; $4,000
d. $4,500; $2,500
 Public Policies Toward Externalities
• Tradable pollution permits system
• Reduces pollution at lower cost than regulation
• Firms with low cost of reducing pollution
do so and sell their unused permits
• Firms with high cost of reducing pollution
buy permits
• Result: Pollution reduction is concentrated among those firms with
lowest costs
• Reducing pollution using pollution permits or corrective taxes
• Firms pay for their pollution
• Corrective taxes: pay to the government
• Pollution permits: pay to buy permits
• Internalize the externality of pollution
 Public Policies Toward Externalities

• The types of private solutions

• Moral codes and social sanctions
• Charities
• Self-interest of the relevant parties
• Integrating different types of businesses
• Interested parties can enter into a contract
 Private Solutions to Externalities

• The Coase theorem

• If private parties can bargain without cost over the allocation
of resources
• They can solve the problem of externalities on their own
• Whatever the initial distribution of rights
• Interested parties can reach a bargain:
• Everyone is better off
• Outcome is efficient
 Private Solutions to Externalities

Why private solutions do not always work

• High transaction costs
• Costs that parties incur in the process of agreeing to and following
through on a bargain
• Stubbornness: bargaining simply breaks down
• Coordination problems
• Large number of interested parties
• Coordinating everyone is costly
22. The goal of industrial policy should be that
a. industries yielding the largest positive externalities should receive the biggest subsidies.
b. any industry that produces negative externalities should be heavily taxed.
c. any production process that produces negative externalities should be shut down.
d. all industries that produce positive externalities should be equally subsidized.
23. In some parts of the United States, sugar beets are grown and harvested. The process
of producing usable sugar from the beets generates foul-smelling smoke. A
government policy that limits the emission of smoke by sugar-beet-processing firms is
an example of
a. a market-based policy.
b. a command-and-control policy.
c. tradable pollution permits.
d. transaction costs.
24. Once tradable pollution permits have been allocated to firms,
a. the government controls the price of permits.
b. firms that can reduce pollution only at high cost will be willing to pay the most for the pollution
permits.
c. the value of pollution-saving technology will be lower than the market value of a pollution permit.
d. the Coase theorem is no longer applicable as a solution to reducing pollution.
 Summary

• When a transaction between a buyer and seller directly affects

a third party, the effect is called an externality.
• If an activity yields negative externalities, such as pollution,
the socially optimal quantity in a market is less than the
equilibrium quantity.
• If an activity yields positive externalities, such as
technology spillovers, the socially optimal quantity is
greater than the equilibrium quantity.
 Summary
• Governments pursue various policies to remedy the inefficiencies caused
by externalities.
• Regulating behavior
• Internalizes an externality using corrective taxes
• Issue permits (similar results to imposing corrective taxes on polluters)
• According to the Coase theorem, if people can bargain without cost, then
they can always reach an agreement in which resources are allocated
efficiently.
• In many cases, however, reaching a bargain among the many interested
parties is difficult, so the Coase theorem does not apply.